How Your Social Security Benefit Is Calculated

If you've checked your annual Social Security statement lately, you probably know the size of the benefit you're projected to receive in retirement. But do you know how that number is calculated?

Social Security determines your initial benefit at full retirement age (FRA) using a complex formula that takes into account your earning history, wage inflation, and a present-value calculation. If you want to understand how the math in those formulas works, there's no better person to ask than Stephen C. Goss, chief actuary of the Social Security Administration (SSA).

A widely respected expert on Social Security, Goss has been with the SSA for more than 30 years, working in areas related to health insurance and long-term care insurance as well as pension, disability, and survivor protection. He's been involved in every discussion of Social Security policy reform over the past three decades and has a strong command of the under-the-hood aspects of the program.

I sat down with Goss recently to get a tutorial on Social Security's benefit formulas; an edited transcript follows.

Q: How does the Social Security benefit formula actually work? That is, aside from the timing of my claim, how will my benefit be determined?

A: The 5,000-foot view is that we have a formula called the Primary Insurance Amount (PIA). It is a weighted formula that gives a higher benefit relative to career earnings for a lower earner than for a high earner. If you and your employer have been paying taxes, you have to work enough time to become insured--either for retirement benefits when you are 62 or older, or if you become disabled at an earlier age, or should you die [leaving a benefit for your survivors].

Q: How much time is required to qualify for a benefit?

A: For a retirement benefit at 62, you need to have earned one quarter of coverage for every year that has passed since age 22--40 quarters of coverage. So, if you have at least 10 years of work with a significant amount of earnings, you will be insured.

For disability insurance at a younger age--say, at age 42--to be fully insured you only have to earn half as many quarters of coverage. But there is another test called the recency test. You must have worked five out of the last 10 years to qualify.

We have a straightforward formula for determining the PIA. First, we calculate your average indexed monthly earnings (AIME). That involves taking any years of earnings that you had before you reached age 60 and indexing them to put them on more of a proper comparative basis with the earnings level in our society as of the year you turned 60. That is done using the average wage indexing series that the Social Security Administration (SSA) computes every year.

Q: So, AIME is a sort of inflation adjustment, but one that uses wages, not consumer prices?

A: Exactly--it reflects the average wage in the U.S. economy. That usually rises about 1% faster than consumer prices. It is just a way of making all your years of earnings comparable relative to what the average earnings level in the economy was in those years.

Q: And then you use only the highest 35 years of earnings to compute the PIA?

A: For a retirement at 62 or older, you'd take your highest 35, and on that wage-indexed basis, we simply average those. If you only had 30 years of earnings, we still take the highest 35 and will include five zeros. So, it is your best 35, including zeros if necessary. We average that out and express it as a monthly amount. That becomes your average indexed monthly earnings (AIME).

That is the first component. Next, we take the AIME and apply it to the PIA formula. It's a bit like the income tax structure, where for AGI in the first segment bracket of your earnings, you might pay a low tax rate, and for AGI in higher brackets, you pay higher tax rates. With the PIA formula, you get 90% of AIME for the first segment, which we call "bend points." This year, that covers the first $826 of monthly AIME. For the next segment, between $826 and $4,980, you get 32% of AIME. For any AIME amount above $4,980, if you are a relatively high earner, you get 15% of AIME.

Q: That is one of the most important ways that we have built progressivity into the system. There are others, such as the special minimum benefit provision or auxiliary benefits.

A: Exactly. For a person who is a very low earner, that first PIA bend point is at about the 10th percentile of all of our retiring workers. So, very few people are getting that full 90% return of their AIME. Most people are up into that middle segment. And the average is somewhere around 45% of the ratio of PIA to AIME.

Q: How does the timing of my benefit claim figure into all this?

A: The age at which you decide to start receiving benefits matters. We use an actuarial reduction factor that many people are familiar with. If you wait until the full or normal retirement age--which currently is 66--your monthly benefit level will be exactly that PIA.

Now, let's say you want to start receiving retirement benefits at 62, which is the earliest you can claim. Then, you will get a reduced benefit for the rest of your life. The PIA would be reduced by 25%--you'll get 75 cents per dollar of PIA paid to you on a monthly basis at 62, and you'll continue to have that reduction for the rest of your life.

If you wait until after normal retirement age to start benefits, you get something called the "delayed retirement credit," which works out to 8% for each 12-month period you delay. If you wait one extra year beyond normal retirement age, you get 108% of your PIA. If you wait a second extra year--until 68--you'll get 116%, and so on. You can do this up until the year you turn 70.

Q: The formula is based on the average mortality of the population, right?

A: Yes, it's based on the average mortality we have in our society for men and women on a combined basis--and the interest rates we are operating under for discounting. So, [it's based on] a present-value-discounted basis and our forecasts for longevity.

Q: Social Security applies an annual cost-of-living adjustment (COLA) to benefits using an automatic formula tied to the Consumer Price Index; how does that adjustment figure into the decision to file early or not?

A: The most important thing to know is that the COLAs are applied to your benefits starting in the year you turn 62, no matter if you have filed for benefits or not. Let's say you wait to file until age 66, and there has been 10% inflation between the time you are 62 and 66; then that $1,000 PIA will, just by virtue of COLAs, have risen to $1,100 at your full retirement age. If you take your $750 benefit at age 62, you'll get the same COLAs, and the $750 will increase by 10%, which is $825. So, either way, you get the COLAs applied from one year to the next, and they start immediately after you're first eligible for benefits.

Q: Going back to the calculation of the benefit and earnings, you mentioned that the highest 35 years of wages go into the calculation--and that if you only worked 30, you'd have five zeros. What is the implication of that for people who have been out of work for an extended period of time? Is there anything these folks can do to rebuild their future benefit levels while they are still in their working years?

A: We're basically looking at a 40-year career from age 22 to 62. If you have five years or more without work within that time frame, you will have a slightly lower AIME. But the good news is, if your AIME is lower because you have less than 35 years of work, then you are not reduced proportionately, because then your AIME will be more focused on that lower end of the PIA formula, where you get 90%.

Q: It sounds like people who have been jobless can catch up a bit if they go back into the workforce in the years leading up to filing for Social Security--perhaps even part time?

A: Any earnings you have in a given year have the opportunity to go into being in your highest 35. An important point here is, if you have filed for benefits at age 62, we look at all of your years of earnings from age 61 and earlier and take the best 35. But let's say you had five zero years and you then work part time and earn $10,000 in the next three years. Each succeeding year, we go back and recalculate your PIA, replacing one of those zeros with those new earnings. So, you are getting credit all along the way. This happens if you work up to age 70, 75--we will continue to, each year, recalculate your benefit if you have had more earnings.

And here's a [reason] to consider doing that. Where we indexed your earnings up to age 60, you might think that perhaps ... any earnings after age 60 ought to be indexed down for average wage growth, but that is not done. So, earnings levels that you might have after age 60 have the opportunity to enter into the AIME calculation without any indexing. In effect, that gives you extra credit. (See this online SSA calculator, which allows you to run what-if simulations using your own past and projected earnings.)

Q: What happens if I claim benefits at age 62 but continue to work?

A: That can affect your benefit if you're earning over a threshold (roughly $15,000) and you are under the normal retirement age. We have an earnings test for people prior to attaining age 66. We reduce your benefit by about $1 for every $2 of earnings above that until you reach the full or normal retirement age, at which point there is no earnings test.

Q: And am I right that the withheld benefit dollars are returned to you after 66? It's not a permanent loss?

A: It's not lost. People sometimes mistakenly refer to the earnings test as though it is a tax or penalty. It's really not. It is calculated back into your benefit when you reach full retirement age.

Q: Lastly, there's been a lot of talk about the cap on the amount of wages that are subject to payroll tax and eligible for the benefit calculation. This year, it's $118,500. Why is there a cap on the amount of covered earnings in the first place? What is the history and policy rationale for it?

A: There's always been a cap. For quite a few years, it's been in the law that it is automatically adjusted to rise by the rate of growth in average earnings. And it happens that where the cap is positioned now, by happenstance of the law, the earnings of 94% of all workers fall below that $118,500 cap. About 6% of workers have earnings above that. So, a portion of their earnings is not covered under Social Security.

The rationale, as best one could speculate, is that for people who earn much, much more than $118,500, if we eliminated the cap and gave them the full credit, then they would be getting a 15% return under the PIA formula for the portion of their AIME that exceeded this level. And one thought on that is, for people who have earned that much, do they really need a higher benefit?

The second consideration is, for people who have earned at those higher levels, they would be getting a rather low rate of return--they would be paying in the full 12.4% between them and their employers, but only getting 15% on the margin.

Q: Has the percentage of workers above the cap been rising in recent years?

A: The percentage above the cap has really been pretty stable at about 6%. What hasn't been stable, though, is the share of all earnings that people have that are above that cap. What has happened over the years is a well-known story--the distribution of earners by earnings level has really changed. Sometimes, this is referred to as dispersion--the relationship between the level of pay for the very highest paid and the lowest paid has really changed a fair amount in our society.

We see the clear evidence of that by simply looking at this statistic: Back in 1983, the last time there was an explicit setting of this taxable maximum by the Congress, they set it with a desire to have about 90% of all the covered earnings fall below the taxable maximum. And, lo and behold, in 1983 and 1984 that was achieved. Since that time, because of different relative growth rate and earnings levels for high earners versus low earners, we're now in a position where it's not 10% of all covered earnings falling above the max, but about 17.5%.

Q: That is the effect of income inequality--galloping wage growth at the very highest level?

A: Yes, higher relative growth rates at the high end rather than the low end. And remember that the taxable maximum is indexed by the average earnings level, so if we have people at the high end having greater gains than people at the lower end percentage-wise, then we wind up with more of the overall earnings going above the taxable maximum.

Q: When you hear people discussing various Social Security reform proposals either to scrap or lift or adjust the cap on covered earnings, what are your thoughts about how you could calibrate those two sides of the equation?

A: Our office does estimates for policymakers on all kinds of changes, and as the actuaries, we are completely agnostic as to what would be the appropriate thing to do. A fairly popular proposal that has been put forth is to raise the taxable maximum just enough to get back to having 90% of all earnings covered under Social Security.

Q: What would that be?

A: That would be a little more than double our taxable maximum of $118,500--it would rise to around $240,000. Most proposals that have suggested this would do it on a very gradual basis. For example, the Simpson-Bowles commission proposed that, each year, when we index up that taxable maximum by the rate of growth in the average wage, we add an extra 2% to that growth rate until we get to the point where we are capturing 90%. That would take about 38 years.

Q: And that has been a general guiding theme in most changes to Social Security--they have been introduced in a very graduated way.

A: Absolutely. For instance, the increases in the full retirement age were phased in in a very graduated way; it's the poster child for gradual. It was enacted in 1983 and didn't even start to have any effect until the year 2000. Changes to the program have been gradual from one generation to the next; that has always been the case.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.